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EQUITY OPPORTUNITIES IN A DOWNTURN

Three portfolio managers share insights about long-term value investing in equities during a slump

July 17, 2018

By Devan Daniel

8 min read

Sri Lankan equities are in a prolonged slump, with the market declining 15.2% in the 42 months to 22 June 2018, but these portfolio fund managers are bullish on stocks as long-term investments. Niloo Jayatilake, head of investments at listed, Rs66 billion revenue Softlogic Holdings, is undaunted by the market’s poor showing, having seen worse in the past. Over the long term, the market’s trajectory is always upward, and the best way to capture those gains is through value investing.

JB Financial Chief Executive Christine Bandaranaike believes in this strategy, but says this is highly risky for short-term investors. JB Financial manages assets worth over Rs10 billion in several portfolios. Its Rs2.3 billion JB Vantage Value Equity Fund has returned 14.9% annually over five years since 2014, the highest for any mutual fund according to Unit Trust Association of Sri Lanka data. During this period, the All Share returned just 1.87%.

Ceylon Guardian Senior Fund Manager Asanka Jayasekara is a believer in fundamentals, where investment decisions are contrary to what earnings and share prices suggest. For instance, over the last three years, while the All Share declined 4%, combined earnings of listed companies grew 15%, he says. Jayasekara oversees the Rs445 million Guardian Acuity Equity Fund which gave a five-year annual return of 8.6%.

Buy value. Buy out-of-favour stocksJB Financial, which manages the Rs2.3 billion JB Vantage Value Equity Fund, is investing in stocks that are not only undervalued but also out of favour—these stocks may even underperform when the market rallies because typical investors don’t find them attractive enough.

However, these stocks shine when the underlying economy grows giving credence to those who believe value always outperforms market growth over the long term. The objective of the fund is to achieve long-term capital appreciation through investments in shares of companies with strong appreciation potential that is not reflected in their trading prices.

“We buy companies that are not in favour, but have the potential to be in the long term,” says Christine Bandaranaike, chief executive of JB Financial.

“We don’t buy typical blue-chip stocks where prices already reflect their value. We uncover value that has not been uncovered. This gives us an opportunity to create alpha stock returns that outperform the market over time,” Bandaranaike says. The danger is that these stocks may take a hit during a downturn or are unlikely to grow as fast during a rally. Over the long term, however, value will have its day.

In a falling market, most investors pull out. Some, not wanting to miss out on the upturn, invest in safe index funds like those tracking the S&P SL20 index of liquid stocks or buy shares of large dividend-style companies. But JB Financial believes in a contrarian approach, investing and stubbornly holding on to unfavoured stocks.

Investors coming into the JB Vantage Value Equity Fund are told they need to expect volatility and risk, and there’ll be no trading for short-term gains. “Equity investing is a stayer’s game, and investors must expect volatility and some lean years,” Bandaranaike says.

The equities market is due for a rally. Corporate earnings are encouraging despite low business and consumer sentiment, Bandaranaike says. When the market will turn around is anybody’s guess, and there’s more uncertainty with elections due in 2019. “This is why it’s important to stay invested for the long term,” Bandaranaike says. She believes a 20% allocation in equities is safe, as this gives investors breathing space during bad spells. “Equities should be viewed as part of a diversified portfolio, so at any given time, there are assets that are performing well.”

Sound fundamentals trump falling earnings, share pricesIn a sentiment-driven equity market, fund managers find opportunity to pick shares of companies delivering earnings growth or demonstrating future earnings potential. However, falling prices makes it challenging for fund managers to justify their decisions to jittery investors. This can become harder when a company’s profitability is actually taking a hit, but Asanka Jayasekara, a senior fund manager at Ceylon Guardian, decided to do just that. He began allocating Dialog, a telco, to the Rs445 million mutual fund managed by the firm, the Guardian Acuity Equity Fund.

“This was a company that was perceived to have some serious earnings challenges,” Jayasekara says.

The telco’s share price was falling because revenue was impacted by cost increases, a slowdown in international call revenue, write-offs in older technology infrastructure and new taxes. “We realised that Dialog, in fact, had a strong revenue model driven by data. Data is not just a utility service but can have a multiplier effect and improve the overall efficiency of the economy. For these reasons, we realised the government cannot continue to overburden telcos with ad-hoc taxes,” he says. Jayasekara is prevented by non-disclosure rules from divulging actual trades, but says the fund began buying Dialog when the share was falling. The share has gained around 25% since it reached the bottom. Since inception, the Guardian Acuity Equity Fund has returned 10.4% annually, impressive compared to the All Share’s return over the same period of 2.9%, but not so impressive compared to risk-free annual returns of 9.6% in government securities and 10.7% in safer bank fixed deposits. The mutual fund has a 94% allocation in equities on expectations of a long overdue rally.

“We made a good return on the Dialog investment. The fundamentals were strong despite the earnings slowdown and share prices falling. By investing in the downturn, we’re positioned to capture the market rally early when it comes,” Jayasekara says.

Convincing investors to invest for the long term can be challenging during lean periods. Jayasekara had looked at where the All Share Index ended each month since 2000 to March 2018. He found that, for any given five-year period during 2000-18, the probability of the All Share beating bank deposit returns was around 74%, irrespective of when the investment was made, during a slump or at the tail-end of an upturn. “There are companies with attractive earnings potential that is not reflected in the share price purely because of negative sentiment. However, when sentiments over political stability and the economy improves, these are the stocks that will drive the market rally,” Jayasekara says.

Downturn as an opportunity“We thought the world was going to end in 1997,” recalls Head of Investments at Softlogic Holdings Niloo Jayatilake, then a rookie fund manager. That year, capital fleeing the East Asian economic crisis wiped out half of the Colombo Stock Exchange’s value.

“Around that time, a senior fund manager told me, ‘buy when foreigners sell, and sell when foreigners buy’,” Jayatilake says. It was an important lesson to the young fund manager. Don’t be swayed by sentiment. Accept market cycles. Embrace downturns. The last five years have been good to global equity markets, but not in Sri Lanka.

The MSCI Frontier Markets Index gained 32.32% in 2017. MSCI’s emerging markets index grew nearly 24%. Sri Lanka’s All Share Index gained 3% that year, declining more than 2% during the first six months of 2018. But Jayatilake sees opportunity.

Sri Lankan equities are trading at a 12-month trailing price to the earnings multiple, also called the price-to-earnings (PE) ratio, of 10 times. This means investors are willing to pay Rs10 for each rupee in earnings a company makes. This valuation is less than the 10-year average of 14.9 times. For Jayatilake, low valuations are a good sign.

In 2009, the market was trading at an earnings multiple of 16.6 times, and a higher 25.2 times the following year.

“Today’s equity market PE is at the lowest point, so why are we acting like it’s the end of the world? If we’re not investing now, we’re wasting an opportunity,” she says.

“It is a good time to invest for the long term if you can back your decisions with proper research into the companies. It may not be a good short-term strategy, but these are ideal conditions for longer-term gains.”

“The power to hold is key to success in this business. High-net-worth individuals are amazing because they have held on to key blocks of shares through all the cycles and built their wealth this way,” Jayatilake says. “In most cases, they’ve been more successful than institutional investors who have the money and staying power, but not the discipline.”

After the 1997 East Asia crisis, it took nearly five years for the Sri Lanka equities market to recover, crossing 1,000 points in June 2003. “That was not the first time the world ended,” Jayatilake says, “It ended again in 2008.

“That year, the global financial crisis that unfolded in 2007 cut the value of Sri Lankan stocks by half. In 2012, equities lost more than 40% in value when regulators began looking into market manipulation after the benchmark index reached a month-end peak of 7,800 points in 2011.It took three more years for the index to again breach the 7,000 mark in 2015, but has since declined 11.2% to 6,218 points by mid-June 2018.

“I’ve seen much worse,” Jayatilake says, laughing. “The economy is not in disarray as sentiment suggests; it’s just that people don’t believe anymore,” she says. “However, I am excited about the current period. As a professional fund manager, I embrace these kinds of situations to build the portfolio.”

According to published figures, Softlogic Life Insurance has a life fund of Rs10 billion with 20% in equities—under the 40% maximum limit allowed by regulation—a decent allocation for any investor. In 2017, the entire insurance industry portfolio had less than 10% in stocks.